Disclaimer: Any opinions expressed, potshots taken, or scientific views articulated are mine, and need not represent the opinions, potshots, or scientific views of the Federal Reserve Bank of St. Louis, or the Federal Reserve System.

Wednesday, October 31, 2012

Kocherlakota Joins the COGCB

What's the COGCB? Club of Goofy Central Bankers. Case in point: his speech yesterday. Kocherlakota tells us, if we didn't already know, that

...the Fed’s policy stance is considerably more accommodative than it was five years ago.

Of course, in terms of what the Fed says it cares about (the twelve-month rate of increase in the pce deflator and the unemployment rate), the Fed has been considerably more accommodative than it would have been, pre-2008, if the same state of the world had occurred, as I pointed out here. Thus, the behavior of the FOMC has changed. Either it cares about some things it did not care about before (and in a particular way), or it cares about the same things in different ways - in particular it is less concerned about its price stability mandate.

The Fed may have good reasons for changing its behavior. If so, Fed officials should articulate those reasons in public, so that we can debate the issues. That seems to be what Kocherlakota is attempting here, and he goes even further than you might expect. His conclusion is:

...monetary policy is, if anything, too tight, not too easy.

If you have not fainted and fallen on the floor, take a couple of deep breaths, and we'll figure out what Narayana has on his mind. His argument is:

1. We had a big shock, and this calls for extreme measures.
2. The current inflation rate is too low.
3. Forecast inflation is too low:

Current monetary policy is typically thought to affect inflation with a one- to two-year lag. This means that we should always judge the appropriateness of current monetary policy using our best possible forecast of inflation, not current inflation. Along those lines, most FOMC participants expect that inflation will remain at or below 2 percent over the next one to two years.

Big shock: Of course we had the big shock - four years ago. Now, in 2012, what is it about that big shock that creates macroeconomic inefficiency that can be corrected by central bank action - and by central bank action that has not already been executed? Prices and wages are so sticky they have not adjusted? We are in the midst of some coordination failure that Ben Bernanke (or Narayana Kocherlakota for that matter) can fix? What? There has been massive intervention on an unprecedented scale, and the Fed was in the midst of a transformation of the maturity structure of its asset holdings when it embarked on its most recent asset purchase program. How much is enough? I'm sure you don't have any idea, and I'm afraid the Fed, in spite of its brave front, really has no idea either.

Is the inflation rate too low? It depends how you measure it. The Fed's inflation target is 2%, as measured by the pce deflator. The inflation rate, August 2011 to August 2012, is 1.5%, which is the number Kocherlakota uses. From September 2011 to September 2012, the number is 1.7%. If we look at a shorter horizon, the annualized percentage increase in August was 5.0%, and in September was 4.7%. If we look at a longer horizon, as I did here, from the beginning of 2007 or the beginning of 2009, you'll get something a little higher than 2.0% (I didn't have the most recent observation in the chart in the previous post). Too low? I don't think so.

Monetary policy should respond to forecast inflation, not actual inflation. You would think Kocheralakota would know better. Does a forecast give us any more information than what is in the currently available data? Of course not. It's the currently available data that we use to make the forecast. Further, the "best possible forecast of inflation" is not very good, in general, and the Fed's forecast of inflation is suspect. Any economic forecast is 90% judgement and 10% model, and the judgement of Fed forecasters is going to drive the forecast to something that justifies current policy actions. Arguing that the the Fed's forecasts could justify a more accommodative policy than what we already have is nonsense.

On April 8, 2010, Kocherlakota said this:

Deposit institutions are holding over a trillion dollars in excess reserves (that is, over 15 times what they are required to hold given their deposits). These excess reserves create the potential for high inflation. Suppose that households believe that prices will rise. They would then demand more deposits to use for transactions. Banks can readily accommodate this extra demand, because they are holding so many excess reserves. These extra deposits become extra money chasing the same amount of goods and so generate upward pressure on prices. The households’ inflationary expectations would, in fact, become self-fulfilling.

So the Kocherlakota of 2 1/2 years ago had some worries about the potential for inflation. Maybe he changed his mind for good reason? I don't think so. The new Kocheralakota seems to be a flimsy-excuse guy.

Addendum: Kocherlakota goes on in the same speech I quote from in the last paragraph to say this:

I hasten to say—and I want to stress—that I view this scenario as unlikely. For it to transpire, the country would need a combination of bad monetary policy and poor fiscal management. I do not foresee this combination as likely to occur.

That's important. We now have bad monetary policy and poor fiscal management (whoever is elected President next week - worse if it's Romney). The stunning thing here is that the old Kocherlakota didn't imagine that he would be the source of the bad monetary policy.

I know little about this Kocherlakota. But he seems to be an intelligent man who revises his views in the light of fresh data. If I were young and curious about economics I would certainly want to study his work.

Although theories shouldn't be tested by polls, even polls of top flight economists, the level of disagreement and uncertainty about the effects of QE3 in this poll suggests that the contemporary science of monetary economics is, not to put too fine a point on it, unsettled.

Excess reserves do not have the potential for inflation if the Fed sells assets to hit inflation targets. The early-80's showed the Fed has essentially unlimited ability to fight inflation if it wishes.

The big issue with this post is focusing on inflation rates vs. price levels. The inflation rate went back to 2% (or really 1.5%) levels. But price levels only got back to 2008 levels a year ago. Due to the 2008-2009 deflation, it was as if we had 0% inflation from 2008 to 2011.

0% inflation shouldn't cause unemployment theoretically, but firms have a distribution of demand. At 0% inflation, more firms have declining overall revenue . With economies of scale and limited number of firms, all firms in a sector can have an equilibrium where they cut costs through cutting employees vs. cutting wages.

When an employer cuts costs, they don't cut costs past the cuts needed just to rehire different people at a lower wage. The turnover costs make that a very dumb decision. Instead, unemployed workers find themselves unable to undercut the workers earning higher than market wages because they cannot start their own companies due to economies of scale. The only way they can begin working again is to wait for attrition among those left employed. Only then will an employer have more demand than workers to fulfill orders.

Furthermore, at worst pure monetary inflation of 4% vs. 2%, or 2% vs. 0%, moves everybody's wages up. If labor markets are completely clearing, then 2% inflation means 2% higher wage levels with no change in real GDP. But in the world where sticky wages last for many years because employment turnover only happens due to attrition, higher inflation brings the actual wages much closer to the real market-clearing wages. At some point, the costs of inflation outweigh the marginal effect on unemployment, but we are *far* from that point today. The worst case scenario of having purely structural unemployment with 4% inflation is far outweighed by the much more likely scenario that 4% inflation will significantly reduce unemployment.

No, he does not mean the monetary base. He invokes Gary Gorton and others in his broader definition of money. See here: http://macromarketmusings.blogspot.com/2012/07/safe-assets-money-and-output-gap.html

This quote is from a 1980 piece (http://www.nber.org/chapters/c6264.pdf), but it applies well today. Lucas was expanding on some ideas from Friedman, from much earlier. Friedman of course was skeptical about macroeconomic policy intervention, in part because of how ignorant we are about how the economy works, for example in response to unprecedented interventions such as QE1 through QE3, etc. Here's the whole paragraph:

"As an advice-giving profession we are in way over our heads. TheEmployment Act of 1946 placed heavy demands on the ability of economiststo guide executive authority granted very broad powers. In theearly postwar years, and even through the sixties, it appeared that theframework provided by the Keynesian theory of income determinationwas, intelligently applied, capable of meeting these demands. As confidencehas ebbed in our ability to use general monetary and fiscal policyto carry out the aims of the Employment Act, professionals and nonprofessionalsalike have turned to a wide variety of complex, selective interventionsin individual markets. Even to begin to assess the likely consequencesof these policies in anything like a scientific way is clearly wellbeyond the current limits of our discipline."

Just curious: did you (Williamson) support austerity in Greece or elsewhere in the EU in 2009 or after? Backstopping of EU-member sovereign debt by ECB? US fiscal stimulus at any point during or after 2008? On what grounds, in each case? I ask rather than search your archives not only because I'm busy and lazy (think you can't be both? think again!) but because I'm often mystified by your posts even when you appear (in comments) to think them clear. In other words, I'd love straight answers to these questions, if you care to share them.

Williamson is definitely correct here. Too low? What planet is Kockerlakota on? As recently as 2008, it was at 2.5 percent. Now the core PCE deflator has been below 2, but careening upwards, since the crisis. http://ycharts.com/indicators/us_core_pce_inflation_rate

Inflation too low? What planet is Kocherlakota on?

(OK OK, core pce inflation, at 1.6%, itself is trending lower, but the 3rd derivative of the price level looks to be ticking up in a way which could become untethered...)